Goldman: Trump rally will spike, then fade in 2017 as Fed hikes 4 times

The Trump rally will continue into the early part of 2017, then drop off as the Fed hikes interest rates more than the market expects and sentiment shifts, Goldman Sachs predicts in its forecast for the coming year.

At its core, the outlook sees a tale of two trades: "Hope" that dominates in the first half, then "fear" that takes over the rest of the way.

The good news it that even with a second-half pullback, Goldman has raised its full-year forecast. When all is said and done, the S&P 500 will close at 2,300, a gain of nearly 5 percent from the current level and 100 points higher than the initial 2017 call, the bank's strategists said.

The bad news is that will be a 100-point drop from the expected high achieved in the first half.

"U.S. equity investors have focused 'more on hope than fear' since Donald Trump's election. Ironically, many commentators believe his campaign rhetoric focused 'more on fear than hope,'" David Kostin, Goldman's chief U.S. equity strategist, and others wrote in a report. "In 2017, we expect the stock market will be animated by competing views of whether economic policies and actions of President Trump and a Republican Congress instill hope or fear."

Fear, on the other hand, would come into play when inflation starts jumping, labor costs accelerate and the Fed springs into action. While the U.S. central bank's current forecast is for two rate hikes next year, Goldman's projection calls for the Fed's short-term rate target to rise by 100 basis points, or a full percentage point — the equivalent of four quarter-point hikes.

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There could be other problems as well when Trump tries to implement some of the more controversial portions of his agenda.

"Congressional deficit hawks may constrain Mr. Trump's tax reform plans, and the (earnings) boost investors expect may not materialize," Kostin said. "Potential tariffs and uncertainty around other policy positions may raise the equity risk premium and lead to lower stock valuations in" the second half.

One thing that could mitigate the second-half pessimism is a shift in investor cash.

Goldman sees a possibility of investors losing money on bonds as inflation picks up, pushing them into stock funds. Actively managed mutual funds in particular have witnessed huge outflows despite the seven-year bull market, with U.S. outflows of more than $236 billion in the past year alone, according to Morningstar. If bond yields rise and prices go down, that could swing money from fixed income into equities.

"Policy uncertainty introduces a degree of instability to our 2017 forecast that has been absent in recent years," Kostin wrote. "Uncertainty always exists when forecasting, but our projections for next year have more elements of instability than usual."

As for how the trade plays out, Kostin believes that in the first half, "cyclical" stocks will beat out defensive shares, with companies having high domestic sales and high tax doing well on the expectation for lower tax rates. As both inflation and rates rise, the second half will be better for companies that have low labor costs and strong balance sheets.